Design and implementation of Staging Criterion in line with IFRS-9/ IndAS-109- Not So Straight forward

Introduction

IFRS-9 is a principle- based standard. Like all principle-based standard / guidelines, the application of different facets of this standard on ground requires critical thinking and rigorous application of mind and most importantly requires a learners’ mindset. It tests your objectivity and independence and even integrity, since choice of the approaches has serious implications on the reported profit/ loss of the entities.

For assessment of Significant increase in Credit Risk, as part of identification of Stage-2 facilities, the standards list multiple indicators, which organizations may consider along with backstop measures such as 30+DPD. The subsequent sections deal with 2 issues / scenarios, which banks may come across during design and implementation of Staging criteria.

Evaluation and Implementation of Staging Criterion designed around increase in PD %

Consider the following paragraph (Para B.5.5.10 of IndAS-109)

“The risk of a default occurring on financial instruments that have comparable credit risk is higher the longer the expected life of the instrument; for example, the risk of a default occurring on an AAA-rated bond with an expected life of 10 years is higher than that on an AAA-rated bond with an expected life of five years.”

Further as per Para B.5.5.12, when assessing the significant increase in credit risk of facilities since initial recognition, the entities are expected to consider following factors

§? Change in the risk of default occurring since initial recognition

§? The expected life of the instrument and

§? Reasonable and supportable information that is available without undue cost or effort that may impact credit risk

Certain financial institutions include Increase in absolute PD percent associated with facilities as on reporting date in comparison with date of origination as one of their staging criteria. In this regard, while evaluating this criterion, many institutions consider increase in 12- month PD; not lifetime or cumulative PD. However, considering the guidance provided in Para B.5.5.12 and Para B.5.5.10, the evaluation of this criterion with reference to increase in cumulative PD seems to be a better approach as compared to 12- month PD, because 12- month PD does not factor in the expected life of the facility.

This section does not in anyways disregard the conclusion arrived in Para B.5.5.13, which states that increase in risk of default over next 12 months is a good proxy for increase in lifetime risk of default, it merely suggests a better approach which factors in both expected life and risk of default in next 12 months.

Assessment of Significant increase in Credit Risk (SICR) at counterparty level vs facility level

Consider the following paragraph (Para 4.30 of RBI’s Discussion Paper on Introduction of ECL framework for provisioning by banks)

“Further, since the significant increase in credit risk implies increase in probability of default and default in any financial instrument is treated as a default by the counterparty, evidence of significant increase in credit risk in respect of any financial instrument would imply significant increase in credit risk associated with the counterparty who has issued such instrument. One could argue, therefore, that the assessment of significant increase in credit risk should be at the level of each counterparty and not at the instrument level. However, the same would be more conservative as compared to IFRS9.”

In the above para, RBI makes a compelling and intuitive argument for assessment of SICR at counterparty level as compared to the facility level mandated by IFRS-9

However, this issue is much more complex than it seems. Consider the following scenario

§? The bank has onboarded borrower M/s. ABC in March 2019 with three term loans. Rating of the borrower was AA and accordingly credit spread of 0.75% was priced in while determination of effective interest charged to ABC.

§? In March 2023 the rating of the borrower was downgraded to BBB and 1 additional Cash Credit facility was granted during that month. The additional facility was priced after considering the spread applicable for BBB (say 1.5%).

§? As per banks’ Board approved policy on Staging of exposures, 2 notch downgrade qualify as a Stage- 2 indicator and hence 3 term loans, which was originated in March 19 must be categorized as Stage- 2, while computation of ECL based provision as on 31st March 2023.

§? Now the key question is regarding Staging of Cash Credit facility originated in March 23.

Since the Cash Credit facility is priced in after considering the spread associated with BBB, it is not appropriate to categorize it as Stage-2 and providing lifetime ECL based provision for such facility.? Spread associated with BBB rating reflects the ECL percent associated with such borrowers. Further No significant increase in risk has been observed since origination of that facility. This seems to be the global consensus.

Globally, in many ECL computation engines such as OFSAA LLFP tool of Oracle, there is pre-built rule (configurable of course) which classifies all new facilities as Stage-1, irrespective of the rating of the borrower. However, RBI’s suggestion seems to tilt towards assessment of SICR at a counterparty level; not at a facility level, since the risk of default is a borrower level attribute.

Conclusion

There are many grey areas, which one would find, during design, refinement and implementation of Staging criteria in line with IFRS-9/IndAS-109. It is important to acknowledge that there no 100% right answers. As practitioners navigating through this domain, an unbiased mind with rational outlook is the best we could hope for.

(Views are personal)

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